Wedgewood Partners commentary for the fourth quarter ended December 31, 2016; titled, “Changing Of The Guard.”
Many shall be restored that now are fallen, and many shall fall that now are in honor. — Horace, Ars Poetica
Wedgewood Partners – Review and Outlook
Our Composite (net-of-fees)i gained +2.30% during the fourth quarter of 2016. This gain compares favorably with the gain of +1.01% in our benchmark, the Russell 1000 Growth Index and unfavorably versus the S&P 500 Index’s gain of +3.82%.
For calendar 2016, our Composite (net-of-fees) gain of +4.55% lagged the gains in both our benchmark (+7.07%) and the S&P 500 Index (11.96%).
Top fourth quarter performance contributors included Berkshire Hathaway, Cognizant Technology, Charles Schwab, Schlumberger, and Tractor Supply. Absolute performance detractors during the quarter included TreeHouse Foods, LKQ, Visa, Mead Johnson and Stericycle.
Top 2016 calendar performance contributors included Berkshire Hathaway, Qualcomm, Schlumberger, Apple, and Priceline. Absolute performance detractors during 2016 included Stericycle, Perrigo, Express Scripts, M&T Bank and TreeHouse Foods.
During the fourth quarter, we trimmed our positions in Express Scripts and Cognizant Technology. We added to our positions in TreeHouse Foods, Visa, and Kraft Heinz. We sold Stericycle. We also initiated new positions in Fastenal and Tractor Supply Company.
Changing of the Guard. 2016 will go down as a seminal year, when so much unexpected change took place at an unprecedented pace. Who could have predicted Brexit, Italy’s constitutional reform, and Trump’s nomination and presidential victory? Financial markets, as always, discount such geopolitical news with ferocious speed. 2016 was the year that interest rates bottomed as the 10-year U.S. Treasury fell to just 1.36%; corporate earnings bottomed after a five-month recession; and oil bottomed after OPEC reversed its two-year strategy of flooding an already oversupplied oil market, breathing life back into a heavily depressed non-OPEC E&P industry and heavily depressed OPEC fiscal budgets.
Even high-yield debt surprised, returning approximately 17% – almost triple the return of investment-grade debt. The early “fear” of a Trump presidency dramatically turned into a bull-run of “animal spirits” after the election.
The biggest winners in the stock market were those stocks that had been crushed in the past year(s). Our top four performers in 2016 were among our worst performers in 2015, as all four posted negative returns in 2015. 2016 will also go down as one of the tougher years for active investors in recent memory. It was an environment in which it was difficult to deliver benchmark outperformance, and while the five-quarter earnings recession ended, out-sized earnings growth was difficult to deliver for most of corporate America. Wall Street is always a demanding mistress who shouts, “Show me the money!” no matter the economic environment.
In a world starved for growth and yield, investors over the past year also continued to shout, “Send us the money!” The C-suite placated their respective shareholders by distributing the lion’s share of earnings in the form of dividends and outsized share buybacks. Wall Street applauded heartily. Indeed, those companies that chose to distribute the bulk, if not all, of their respective earnings since 2012 have been rewarded quite handsomely by Mr. Market.
Specifically, as calculated by Strategas Research Partners, companies that have engaged in share repurchases have been on a winning streak this entire bull market. Dividend payers have been a winning strategy since 2011. In addition, historic QE-monetary policy has also rendered a debt cost-of-capital tailwind to those poorly financed companies not seen since the credit bubble years of 2006 and 2007.
We at Wedgewood Partners philosophically shout, “Reinvest the money!” We have always preferred to invest in higher quality, less-indebted companies that reinvest the bulk of earnings. We believe that such cap-ex/op-ex is the mother’s milk of future earnings growth. Companies, whereby the reinvestment of earnings has been the priority over distributions, have suffered in the performance rankings since 2012, notably so in 2016. And so have we. Also, in such a low-growth environment, a common C-suite strategy is to “buy growth” in the form of mergers and acquisitions.
Looking ahead to 2017 and beyond, we may be at a changing of the guard moment in terms of Mr. Market’s enthusiasm for the recently favored C-suite capital allocation strategies. According to Leuthold & Co., for the first time ever, corporate America returned over $1 trillion dollars to shareholders (over a trailing 12-month period) in January 2016 in the form of dividend payouts and outstanding share repurchases, exceeding the prior cyclical peak set in 2008. Cash returned as a percentage of sales by industry sector tells a similar tale. Most sectors are closing in on respective 2008 peaks.
Lastly, and most disconcerting, is corporate America’s collective debt load, (again, according to Leuthold & Co.) which has skyrocketed and is approaching 25-year highs set back in late 2007. Aggregate long-term debt has once again reached $6 trillion this summer. Furthermore, long-term debt issued by S&P 500 companies has increased by a none-too-small 75%. The debt for dividend/buyback spigot could shut off rapidly even if interest rates do fall back to summer 2016 lows. (The offset, as it were, is that generational low interest rates have lowered the burden to service more debt.)
Combining the aforementioned use of cash flow with copious amounts of debt, the most common C-suite strategy to expend this capital has been for share buybacks and dividend payments. Success in growing sales and income has been found by buying “growth” via mergers and aquisitions. Relatedly, rare is the company that has successfully grown sales or income organically while issuing debt.
Even a quick perusal of the table below will surprise most with the astonishing increase in debt in almost every major industry sector. A few noteworthy comments: The energy sector’s ratios have been inflated by the depressed state of sales after the most dire, 24-month industry correction in decades, and utility companies have embarked on large ratebased plant expansion in recent years.
The nature of information technology has changed dramatically over the past dozen years. Large, well-entrenched industry leaders may not have much growth inherent in their businesses these days, but they generate cash at historically high levels. Debt funded dividend payments and large-scale share buybacks have become the norm during this cheap-debt era in IT.
Health care, consumer staples, and even consumer discretionary companies have broken the mold in their collective embrace of leveraging up their respective balance sheets with long-term debt. The use of this debt is to “buy growth” via M&A, and of course, to fund capital returns to shareholders.
We should note successful examples of the use of outsized debt by our own invested companies. Consider Apple. Apple generates enough cash ($65 billion in operating cash TTM) that even after spending $10 billion in R&D in fiscal